Transcript monpolicy

Monetary Policy
Chapter 10
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Monetary Policy
• We talked about how the government can use fiscal
policy to try to smooth recessions
• The other major tool they use is monetary policymanipulating inflation and interest rates
• This is not done by the federal government itself, but by
the Federal Reserve Bank
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The Federal Reserve
• Nicknamed “The Fed”.
• Established in 1913 by Congress primarily as the
authority for bank regulation.
• The power to “coin money” was granted to Congress
by Article 1 Section 8 of the US Constitution but this
power was delegated to the Federal Reserve.
• The power to regulate the amount that exists in the
economy was granted to the Federal Reserve in an
attempt to avoid the boom and bust periods of the late
1800s.
• This power allows the Federal Reserve to alter interest
rates without political interference.
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• There are 12 regional Federal Reserve Banks
• Boston, New York, Philadelphia, Richmond, Atlanta,
Cleveland, St. Louis, Kansas City, Chicago, Dallas,
Minneapolis, and San Francisco
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Goals of Monetary Policy
• Provide sufficient money to the economy so that it may
grow at a sustainable rate.
• Dampen the impact of the business cycle.
• Control Inflation
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What is Money?
• First of all what is money and why do we have it?
• The alternative is we could just trade apples for
cheeseburgers, but that is pretty inconvenient
Suppose I grow apples
Tim has a coal mine
Joe cuts hair
Laura builds houses
I want to trade my apples for other stuff, but I have to make a
whole series of trades to get it worked out, and some of it may
be inconvenient to trade (like houses and hair cuts)
• Money (or cash) makes things much more convenient, we can
just trade money for goods and services rather than having to
hold goods we don’t want
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How do we Measure Money?
• Monetary Aggregate: a measure of the quantity of
money in the economy
• Its not so easy to decide exactly what money is-sort of
depends how easy it is to get access to it
• Has become more complicated with electronic
transitions
• The commonly used ones are
• M1 =cash+coin and checking accounts
• M2=M1+saving accounts+ small CDs
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Traditional and Ordinary Tools of
Monetary Policy
• Open Market Operations
– A relatively fine tool that can be used to make
small adjustments. These adjustments can be
daily and often occur without much fanfare.
• Targeted Interest Rates
– A relatively blunt tool that can be used to make
large adjustments. Changes in targeted interest
rates typically occur a few times per year.
• Reserve Ratio
– A rather blunt tool that is only used when very
large adjustments are in order.
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Tools of Monetary Policy:
Open Market Operations
• The Fed buys US government debt in order to get cash
into the economy.
• The Fed sells US government Debt in order to get cash out
of the economy.
• More money in the economy puts downward pressure on
interest rates.
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Tools of Monetary Policy:
Targeted Interest Rates
• The Fed seeks to influence the Federal Funds Rate (the
rate at which banks borrow from one another to meet
reserve requirements)
• Fed Loans Directly to Banks
• Banks with good credit pay the primary credit rate and can
borrow unlimited amounts.
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Tools of Monetary Policy: The
Reserve Ratio
• When a bank takes a deposit into an account on which
a check can be written, it must place a percentage of
that deposit on reserve at a Federal Reserve bank. That
percentage is called the reserve ratio.
• The Fed directly controls the percentage of deposits
that banks must have at their regional Fed bank.
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Money Creation
• The banking system can create more “money”
than physically exists in the form of coin and
cash.
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• The banking system creates money by a series of
loans.
• Sal makes a $1000 deposit at Chase
• Chase loans Mary $900 who buys something
from Sue
• Sue makes a $900 deposit in Citibank.
• Citibank loans $810 to Bill who buys something
from Allen….. and so on.
• In the end there are deposits totaling $10,000
($1,000+$900+$810+$729+....) that resulted from
that initial $1000.
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Modeling Monetary Policy
• If the Fed wants to expand the economy it can
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buy bonds
decrease the Federal Funds or Discount Rate
lower the reserve ratio.
This increases the supply of loanable funds. This
lowers interest rates which increases aggregate
demand.
• If the Fed wants to contract the economy it can
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sell bonds
increase the Federal Funds or Discount Rate
raise the reserve ratio.
This decreases the supply of loanable funds. This
raises interest rates which decreases aggregate
demand.
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expantionary MoNetary Policy
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AS
Interest
Rates
Price
Level
r
AD
Loanable funds
RDGP
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Contractionary Monetary
Policy
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AS
Interest
Rates
Price
Level
r
AD
Loanable funds
RDGP
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Monetary Transmission
• The Monetary Transmission Mechanism is the
means by which changes in the interest rate
impact the overall economy through changes in
business investment and consumer spending.
• The Fed can impact the interest rate with
monetary policy.
• The Fed cannot count on interest rates changing
business investment and consumer spending.
• When the Monetary Transmission Mechanism fails,
you have a liquidity trap.
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New Tools of Monetary Policy
(Quantitative Easing)
• Purchases of Commercial Paper, short term debt of
corporations.
• Purchases of longer term Federal Treasuries
• Purchases of mortgage backed securities.
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Central Bank Independence
• Countries with Central Banks (the general
name for institutions like the US Federal
Reserve) that are more independent of
political control have higher rates of
economic growth.
• This is because political influences tend to
create inflationary tendencies which
raises interest rates and lowers long-term
investment.
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Fed History 1975-1983
• In the late 1970s, the Fed battled the slow
growth caused by high oil prices by
increasing loanable funds so as to lower
interest rates.
• The result was high inflation and even
higher interest rates.
• The Fed induced the 1982 recession with
contractionary policy. Once inflation fell
below 6% in 1983 it engaged in
expansionary policy.
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Fed History 1984-1990
• The Fed battled high deficits (expansionary fiscal policy)
by keeping real interest rates fairly high.
• The Fed chose not to react to the 1990 recession
hoping to persuade Congress and the first President
Bush to compromise on deficit reduction.
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Fed History 1990-2003
• The Fed steered a stabilization course
through the 1990’s.
• A fear of inflation led to a rapid increase
in interest rates in 2000.
• A fear of recession led to a rapid
decrease in interest rates in 2001.
• The Fed tried to dampen the economic
impact of the Sept 11, 2001 terrorist
attacks with quick and deep rate cuts.
• Rate cutes left the Federal Funds rate at
1% though 2003
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Fed History 2004-2009
• Began raising interest rates in 2004
• Raised interest rates 17 times until the Fed
Funds rate was at 5.25%
• Maintained that rate for several months.
• In 2008, it began cutting interest rates in
response to the economic slowdown.
• Brought the federal funds rate to zero (to
0.25) percent in late 2008.
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Key Interest Rates
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The Inflation/Deflation debate
• The Fed is often criticized by economists
but primarily by politicians for being more
concerned about inflation than
preventing recession or getting the most
out of the US economy.
• There was little the Fed could have done
to stimulate the economy after the final
cut to 1%. There was an active concern on
2003 that deflation was possible
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Aggressive Fed Action on the
Federal Funds Rate (1999-2009)
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Inflation Targeting
• The European Central Bank currently
targets inflation rather than a monetary
aggregate or interest rate.
• Inflation targeting: involves publishing a
desired range of a specified inflationary
measure and then using the tools of
monetary policy to bring that measure of
inflation into that desired range.
• The Fed’s target is the core PCE deflator.
• Target range 1-2%
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European Debt Crisis
• Right now a lot of countries in Europe share a common
currency: the Euro
• Advantage: Makes international trade much easier as it
makes the Eurozone more like one large economy
• Disadvantage: Countries are now limited in using the
central bank to control their own circumstances
• More specifically it takes away an important tool: when
government debt becomes bad enough one solution is
to print money to pay
• In practice the government would issue bonds
• the central bank would print money to buy the bonds (and then
tear them up)
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•Now there is a big issue of what happens if an EU
member defaults on their debt
•One solution for Greece would be to bail on the Euro and
use their own currency to pay off their debt another is to
default
•If either of these happens, confidence in Portugal falls,
then maybe Spain, then maybe Italy
•Since the whole area is tied together, this is a bad
situation for everyone
•For example, a lot of Greek debt is held by German
banks
•For this reason these countries are all tied together
•Of course there is a moral hazard problem: if they bail
Greece out today how will Portugal behave tomorrow?
•Current situation is quite unstable-still not clear exactly
how it will be resolved
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